TheBull PREMIUM

Take Profit - Why A Global Sell-Off is Likely

This column has repeatedly emphasised one investment idea above all others in 2013: buy US equities in unhedged currency terms to profit from a rising US sharemarket and falling Australian dollar.

The strategy has so far provided handsome returns: the iShares Core S&P ETF is up 38 per cent this year. Over one year (to July 31), the ETF is up 46.4 per cent, according to iShares.

I have also identified buying Japanese equities on a significant pullback, and US multinational companies that will benefit from the boom in Asian middle-class consumers. A small increase in allocations towards European equities, a riskier contrarian idea, was also mooted.

Now it is time to consider taking some profits in US equities.

I still like the medium-term outlook for US shares and believe our dollar has further to fall. If anything, news this month about the worsening state of the Australian economy and budget position, and early signs from the current profit-reporting season, strengthens the case to increase asset allocations to international equities at the expense of domestic equities.

Nor do I suggest dumping US equities and rotating funds into other risk assets. Instead, gradually reduce exposure to US equities, take some profits off the table, increase cash weighting in portfolios, and have funds ready to redeploy when global equity markets pull back.

A sell-off in global equities in the next few weeks would not surprise. It may have already started, judging by the market’s reaction this week to talk the US will taper its quantitative easing program.

We are nearing the seasonally weak September/October period and US equities have had a terrific run this year. The US Federal Reserve’s likely move to wind back its stimulus program in the next 6-12 months will be a headwind, China seems more likely to disappoint, and Europe still has plenty of potential crises.

One of the market’s better judges, Evans & Partners, made a similar point about global equities in research note last week. After being strongly overweight global equities and underweight Australian equities in the past few years, Evans has slightly reduced exposure to global and local equities (2 per cent for each in the firm’s well-performing asset-allocation strategy).

The broker said valuation multiples, led by the US, were back at a four-year high, having steadily expanded over recent months. It wrote: “Aggregate earnings estimates continue to drift down – both domestically and globally. In the absence of positive earnings revision, it is difficult to justify ongoing multiple expansion.”

It’s a excellent point. I expect this year’s profit-reporting season in Australia (for companies with a June 30 year-end) to be weaker than the market expects, and for company guidance statements for FY14 to temper analyst expectations. The June quarter US results also showed slowing momentum.

That does not mean global equity markets cannot continue to rise. Bell Potter Securities head of wholesale business Charlie Aitken published a widely reported note this week predicting the S&P/ASX 200 index would hit 6,000 points, from 5011 now, within 12-18 months.

That looks too bullish, but Aitken’s prediction might hold if more investors are forced to buy equities as interest rates continue to fall from already record-low levels. A Self-Managed Superannuation Fund (SMSF) earning under 4 per cent on bank term deposits, and struggling to provide sufficient income to the trustee, can earn double that on some blue-chip industrial shares, and more after franking credits.

The market’s willingness to pay a huge premium for companies with more reliable earnings and dividends growth looks unlikely to stop anytime soon. But there is a huge problem when investors drive share prices higher based on relative yield rather than company fundamentals, and use equities as a surrogate for fixed interest or cash, when shares have much higher risk.

High global valuation multiples, lingering concerns about earnings growth, and super-low interest rates distorting equity markets is a dangerous cocktail. As such, the prudent strategy is to consider taking some profits off the table and lift portfolio cash weightings to fight another day.

US equities are an obvious contender given the extent of gains this year. They are due for a pullback in the next few months and the Australian dollar, while still overvalued, is getting closer to my year-end target of US85 cents.

With limited near-term upside – and rising equity risks in the next few months – it looks a good time to reduce exposure, while still maintaining an overweight position to global equities within portfolios, and within that an overweight position to US equities.

And to turn some paper profits in US equities into cash in your pocket.

Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis are at August 7 2013.

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